A Congressional attempt to legislate a fast-rising method of startup funding called crowdfunding is getting praise for helping legitimize the trend, but also is being criticized for coming up short.
The JOBS Act, mainly designed to smooth the way for more IPOs by young companies, won broad bipartisan support, with the Senate passing the bill 76-22 on Tuesday and the House giving a 390-23 thumbs up the previous week.
But a Senate amendment tacked on Thursday that aims to, for the first time, regulate the crowdfunding trend out of the Wild West and into more regulated channels is attracting critics.
Some say the law could open the door for fraud and the kind of abuse that results in crowds of people losing a good chunk of money .
In crowdfunding, people organized via websites unite to fund a company. The crowdfunding amendment in the JOBS Act would open the way for people to invest as little as $500 or more than $10,000 in startups.
Websites that organize crowdfunding have been around for several years, as the poor economy prodded banks and other traditional startup lenders to be stingier with their funding.
"We are in a cycle where young companies are having a hard time securing private capital," said Melanie Rubocki, vice chairman of the emerging companies practice group at law firm Perkins Coie. "The JOBS Act is one way Congress is trying to get in on the act of how do we stimulate innovation and create more companies.
Rubocki, though fine with the intent, isn't so sure about the details. Under the proposed legislation, "there will be opportunities for abuse," she said. "Our hope is the good outweighs the bad.
The intent of the legislation is to spur innovation that will create jobs, as startup companies are a huge source of job growth.
The traditional startup path is that a founder or founders of a new business tap their credit cards and asks friends and family to loan them money.
As the company grows and more capital is needed, they often look to "angel investors," typically groups of wealthy individuals. The next step, typically, is to get even more money from venture capital firms.
Apple Followed Usual Scenario
This self-friends-angels-VC approach helped launch Apple (NASDAQ:AAPL - News), Cisco Systems (NASDAQ:CSCO - News), Microsoft (NASDAQ:MSFT - News), Intel (NASDAQ:INTC - News), FedEx (NYSE:FDX - News) and any number of today's industry giants.
But the recent recession and lagging economy has crimped the ability of startups to raise funds at all of these levels.
Crowdfunding has started to step in to fill that void.
When you get beyond friends and family, most angel and other investors want some equity in return for their investment. Such investors need to be accredited by the Securities and Exchange Commission as being high-wealth individuals. That effectively limits this group of investors to about 1% of the U.S. population, says William Quigley, managing partner at venture capital firm Clearstone Venture Partners.
So, there are good ideas behind the idea of crowdfunding, Quigley says. But he has misgivings, saying Congress might come to regret endorsing crowdfunding.
"The last place an individual should think about investing their money is a startup company," Quigley said. "These companies have a high risk of failure, and it's unlikely (investors) will be able to get enough information as to whether it's a good investment.
On the other hand, he says Congress needed to get involved, because "all these (crowdfunding) platforms are springing up.
The idea started with websites set up for people to make charitable donations, and sites that link people who want to lend, borrow.
This includes websites such as Prosper.com and LendingClub.com for borrowing money. Websites that fall into the charitable category include Kickstarter.com and RocketHub.com.
The concept has worked. Kickstarter, for example, has received pledges of $170 million from more than 1.5 million individuals worldwide, funding more than 19,500 "creative projects," it says.
Other websites that fit the crowdfunding definition include U.K.-based CrowdCube.com, Hong Kong-based GrowVC.com and Netherlands-based SymBid.com.
In the U.S., crowdfunding wasn't big enough to catch the attention of the SEC, until recently.
With the Internet being used for social and business networks in many areas, startup funding was bound to be next. And the success of such startups as Facebook, Twitter and Groupon (NASDAQ:GRPN - News) spurred the trend, Quigley says.
"That is the real reason this has become a hot area," he said. "Everybody is looking and saying: If only I could have invested in them when they were still startups.
Other organizations that have inspired crowdfunding include Startup America Partnership. Its chairman is Steve Case, the founder of another once hugely successful startup known today as AOL (NYSE:AOL - News).
A goal of Startup America is "to offer strategic guidance on bringing the private sector together to provide startups with the resources they need to start and scale their organizations.
Business observers say there is growing and widespread enthusiasm in the U.S. to provide greater support for entrepreneurs. Crowdfunding fits into that trend.
"It's crucial that crowdfunding move beyond donation model and emerge into an equity model," said John Berlau, who follows the finance and capital markets for Competitive Enterprise Institute, a free market-oriented think tank.
But Berlau is disappointed in the Senate amendment to the JOBS Act as it pertains to crowdfunding.
The amendment, authored by Sens. Scott Brown, R.-Mass., and Jeff Merkley, D.-Ore., puts tight restrictions on who can fund startups and by how much, among other things, Berlau says. He says a House version is better but the Senate version likely will prevail.
"The Senate bill requires mounds of voluminous filings with the SEC," Berlau said. "It also imposes liability for technical mistakes, perhaps even more so than even for a normal public company.
"It's a trial lawyers' bonanza."